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Business Models Generate Winning Investments

It's confession time: Do you buy stocks, or do you buy companies?

Since you're reading The Motley Fool, I have to assume you're in the rare category of astute investors who pick great companies, knowing they'll be winners over the long term, whether or not they're currently in fashion.

Picking winning companies isn't easy. It takes hard work and an investment strategy that separates the wheat from the chaff, so to speak. The retail sector can be particularly difficult, with its intense competition. As soon as one company latches on to a hot product or an appealing display, everyone else is on the bandwagon faster than you can say "Crocs."

Dig beneath the surface
The retailer selling the hottest must-have item doesn't always translate into a profitable investment. Fickle consumers change their minds on what's "in" so rapidly that today's trend could disappear tomorrow, leaving faddish companies out in the cold. That's why thoughtful investors dig beneath the glitz to get to the core of the matter.

Beyond looking for well-liked products, analyzing long-term strategies -- like a retailer's supply-chain management operations -- can help you discover companies that boast tangible strategic advantages and real staying power. Admittedly, that's not the most exciting part of a business, but retailers can gain a definite edge by efficiently moving goods from point A to point B. So which retail companies have the deepest supply-chain moats?

Redefine the environment
Costco (Nasdaq: COST  ) has the supply-chain thing down to a science. The business model is simple. Carry only a few of the very best products in each category, since a limited assortment means faster sell-through and lower markdowns to clear discontinued items. Buy those products in enormous quantities and larger pack sizes than most retailers would even consider, saving on wasteful packaging costs). Then move those goods around the store in pallet quantities with forklifts, saving labor costs.

The result gives shoppers what they crave -- the best stuff at the lowest prices. Look no further than Costco's comps to realize the incredible power of this business model. While the rest of the retail world is trying to figure out how to make money in a flat-to-down comp-sales environment -- Target (NYSE: TGT  ) just reported January comps down 1.1% -- Costco is running 8% comps growth through its first 22 weeks of this fiscal year. It's like Costco operates under a force field that shields it from the economic environment. To my way of thinking, this is moat city.

Redefine the experience
Once, everyone rented videos the same way. Trudge down to your local Blockbuster (NYSE: BBI  ) , hope the title you want is in stock, then rush the movie back to avoid those pesky late fees.

Netflix (Nasdaq: NFLX  ) had a better idea. Carry more than 90,000 titles in a central location to avoid most problems with out-of-stock titles. Offer free delivery in about a day. Let users keep each film as long as they like, eliminating late fees. Then allow customers to mail that film back and get the next flick on their lists.

While we all see this now as a more customer-friendly approach, the core of Netflix success is a supply-chain revolution in the video rental business. Inventory management is much more efficient. Operating costs are low -- Netflix delivers 6.5% operating income compared to -1.23% for Blockbuster. And customer satisfaction remains high; the company gained 451 thousand net subscribers last quarter.

While it's possible that a new entertainment supply chain model is evolving via the Internet, Netfilx remains a classic example of turning an established retail market on its head, building a better mousetrap to get product to customers.

Redefine the offering
Thought your neighborhood drugstore was going the way of the dinosaur? Think again. CVS (NYSE: CVS  ) and Walgreen (NYSE: WAG  ) have redefined the concept into a convenience store plus pharmacy operation. The result offers an assortment that 7-Eleven can't match, and convenience that makes a shopping trip to Wal-Mart (NYSE: WMT  ) feel like a full-day commitment.

But the story doesn't stop here. While this retail channel is delivering enviable sales growth in its current form, it's also in the midst of another transformation, led by CVS's acquisition of Caremark last year. The new face of the drugstore channel is adding in-store health clinics, and integrating upstream into pharmacy-benefits management.

To get an idea of the power and flexibility of this offering, just look at CVS's results for the fourth quarter. The company has only scratched the surface here. While 2007 saw the company integrating its new operations and testing the resulting synergies, we should see this transformation really start to gain traction in 2008.

Wal-Mart and Target are experimenting with in-store clinics, but it appears to me that they aren't fully committed to the idea. I wouldn't be surprised if the entire retail health-care delivery market is already redefined before they decide to get down to business in this channel.

Finding companies that possess these characteristics can be time-consuming, but the rewards from the hard work are well worth the effort. That's why each service at The Motley Fool is committed to finding well-managed companies with unique products that are poised to dominate a mass market with their moats. To discover which companies our analysts are recommending now, take a free trial of any service, free for 30 days.

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